Households with familiarity bias tilt their portfolios towards a few risky assets. Consequently, household portfolios are under-diversified and excessively volatile. To understand the implications of underdiversification for social welfare, we solve in closed form a model of a stochastic, dynamic, general-equilibrium economy with a large number of heterogeneous firms and households, who bias their investment toward a few familiar assets. We find that the direct mean-variance loss from holding an under-diversified portfolio that is excessively risky is a modest 1.66% per annum, consistent with the estimates in Calvet, Campbell, and Sodini (2007). However, we show that in a more general model with intertemporal consumption, this loss is amplified because it increases household consumption-growth volatility. Moreover, in general equilibrium where growth is endogenous, we show that the welfare losses of individual households are magnified further through the externality on aggregate investment and growth. We demonstrate that even when forcing the familiarity biases in portfolios to cancel out across households, their implications for consumption and investment choices do not cancel — individual household biases can have significant aggregate effects. Our results illustrate that financial markets are not a mere sideshow to the real economy and that financial literacy, regulation, and innovation that improve the financial decisions of households can have a significant positive impact on social welfare, equivalent to an increase in the expected return on aggregate wealth of over 10% per annum.

Does Household Finance Matter? Small Financial Errors With Large Social Costs – Introduction

One of the fundamental insights of standard portfolio theory (Markowitz (1952, 1959)) is to hold diversified portfolios. However, evidence from natural experiments (Huberman (2001)) and empirical work (Dimmock, Kouwenberg, Mitchell, and Peijnenburg (2014)) shows households invest in under-diversified portfolios that are biased toward a few familiar assets.1 Familiarity biases may be a result of geographical proximity, employment relationships or perhaps even language, social networks, and culture (Grinblatt and Keloharju (2001)). Holding portfolios biased toward a few familiar assets forces households to bear more financial risk than is optimal. Calvet, Campbell, and Sodini (2007) study empirically the importance of household portfolio return volatility for welfare.2 They find that, within a static mean-variance framework, the welfare costs for individual households arising from underdiversified portfolios are modest. We extend the static framework to a dynamic, general-equilibrium, production-economy setting to examine how under-diversification in household portfolios impacts intertemporal consumption choices of individual households, and upon aggregation, real investment, aggregate growth, and social welfare.

In our paper, we address the following questions. How large are the welfare costs of under-diversification for individual households? These costs are an example of what is often referred to as an “internality” in the public-economics literature.3 Do the consequences of household-level portfolio errors cancel out, or does aggregation amplify their effects, thereby distorting growth and imposing significant social costs? How large are the negative externalities for the aggregate economy because households invest in under-diversified portfolios? Are pathologies such as familiarity biases in financial markets merely a sideshow or do they impact the real economy? In short, does household finance matter?

Household Finance

Our paper makes two contributions. First, we show that even if the welfare loss to a household from investing in an under-diversified portfolio is modest, once we incorporate the effect of an under-diversified portfolio on the household’s intertemporal consumption choice, the internality to the household is amplified by a factor of four. Second, household-level distortions to individual consumption stemming from excessive financial risk taking are amplified further by aggregation and have a substantial effect on aggregate growth and social welfare. Overall, combining the impact of under-diversification on intertemporal consumption and aggregate growth amplifies social welfare losses by a factor of six. Thus, financial markets are not a sideshow – internalities at the micro-level arising from under-diversified household portfolios can create a macro-level externality in the form of reduced economic growth. These results suggest that financial literacy, financial regulations, and financial innovations that lead households to make better financial decisions can lead to large benefits, not just for individual households, but also for society.

To analyze the effects of under-diversification in household portfolios on the aggregate economy, we construct a model of a production economy that builds on the framework developed in Cox, Ingersoll, and Ross (1985). As in Cox, Ingersoll, and Ross, there are a finite number of firms whose physical capital is subject to exogenous shocks. But, in contrast with Cox, Ingersoll, and Ross, we have heterogeneous households with Epstein and Zin (1989) and Weil (1990) preferences and familiarity bias. Each household is more familiar with a small subset of firms. Familiarity bias creates a desire to concentrate investments in a few familiar firms rather than holding a portfolio that is well-diversified across all firms. Importantly, we specify the model so that households are symmetric in their familiarity biases. The symmetry assumption ensures that the familiarity biases cancel out – that is, each firm’s expected share of aggregate investment is the same as when there are no biases.